VRM12 - Applying Duration, Convexity, and DV01 Flashcards
Describe the one-factor interest rate model and identify common examples of interest rate factors
When rates driven by single factor, movement of one interest rate can be used to determine movements of all interest rates over a period
Most common is that if one moves, all move by the same amount
Define and compute the DV01 of a fixed income security given a change in the yield and the resulting change in price
DV01 describes the impact of one basis point change in interest rates on the value of a portfolio
DV01 = - dP / dr
Calculate the face amount required to hedge an option given the DV01 of each
Increase position in bonds proportionally to match DV01s
Define, compute, and interpret the effective duration of a fixed income security given a change in yield and the resulting change in price
Effective duration describes the % change in the price of an instrument due to a small change in all rates
D = - dP / (P*dr) = DV01 / P
Compare and contrast DV01 and effective duration as measures of price sensitivity
DV01 calculates dollar amounts so changes with the size of a portfolio, effective duration doesn’t, so depends on the situation which you shoul use
Define, compute, and interpret the convexity of a fixed income security given a change in yield and the resulting change in price
Convexity measures the sensitivity of duration to changes in interest rates
C = (1/P) * (P(+) + P(-) - 2P)/ (dr)^2
P(+/-) is value of portfolio when r up and down by dr
Describe an example of hedging based on effective duration and convexity
Hedge based on weighted average of duration and convexity
Construct a barbell portfolio to match the cost and duration of a given bullet instrument and explain the advantages and disadvantages of bullet vs barbell portfolios
Use two or more bonds to reconstruct using weights on duration
Barbell always better if parallel shift in yield curve, bullet better in non-parallel shifts.
